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The Easiest Money You'll Ever Make

How to pocket 50 grand doing next to nothing.

Was I a little rough? Yes. Did I bash the mutual fund industry for robbing us blind? Sure. Did I expect some hate mail? I guess, but not this.

Feeling a little lost?Don't worry -- here's a quick summary. In a recent column I proposed an experiment. It was a bogus mutual fund made up of four stocks, each bought in 1992 and sold exactly eight years later.

I chose EMC(NYSE: EMC), Clear Channel(NYSE: CCU), Xilinx(Nasdaq: XLNX), and AOL, which is now part of Time Warner(NYSE: TWX). But any number of former darlings would have done the trick.

The idea was to show how your modest $10,000 investment could have ballooned to more than $2.4 million in eight short years. But there's a catch.

In those eight years, you'd have paid your mutual fund manager about $85,000 in fees and surrendered nearly $300,000 more in lost profits (capital gains not earned on those fees). So, instead of $2.4 million, you'd be sitting on a lot less.

So you hate me, right?Of course you do, but I thought you'd take the fund's side. I thought you'd point out that nobody could pick just those four stocks, much less time the market so perfectly.

In other words, I thought you'd say that my $385,000 blood money is a gross exaggeration, wholly unrealistic, and unfair.

You got worked like a chump!Or so you told me. Apparently, you don't mind my comparing Wall Street to the IRS on steroids. You took me to task for understating the case -- for trivializing the real cost to you as an investor, at least on a percentage basis.

And you're right. John Bogle -- the founder of Vanguard Funds, of all people -- makes the case in his book, The Battle for the Soul of Capitalism. Bogle shows how you don't need blowout returns (like in my superstock '90s example) to make the case against mutual funds ... you need time. Here's why.

Beware the "tyranny of compounding"As it turns out, the scourge Bogle calls financial "intermediation" costs would have eaten just 16% of your total returns ($385,000 out of $2.4 million) in my "outrageous" mutual fund example. That sounded like a lot to me, but apparently not to Bogle -- or to some others. In fact, for most of us, it will be worse.

For one thing, we won't be making 5,900% every eight years, as in my example. That's because for every IPO your skipper catches for a quick pop, he'll surf a Crocs(Nasdaq: CROX) for a death-defying plunge. But mostly, we'll ride the likes of Alcoa(NYSE: AA) and Johnson & Johnson(NYSE: JNJ), right along with the rest of the widely held list.

And even if your fund manager does catch lightning, he'll buy and sell too often and at the wrong times. That's why Bogle says you'll do worse than "average" -- 8.5% per year by his estimate. Plus, you won't invest for just eight years, but more likely 25, 30, or even 45 years or more. Think that's good news? Well, brace yourself, because this thing really gets ugly.

That'll be 80% off the top, sirAccording to Bogle, if you invest for 45 years at his expected return of 8.5% per year, these "intermediation" costs can steal up to 80% of your rightful profits. You read that right. Not a mere 16% like in my ridiculous little scenario, but up to a full 80%. Ouch.

For one thing, Bogle uses a more aggressive 2.5% for intermediation costs. That's because he goes beyond reported "management fees" and includes taxes, transactions, and timing costs. And given that Bogle founded Vanguard, the most trusted mutual fund company in the world, I'm inclined to believe him.

More important, Bogle realizes that the more realistic your returns, the more deadly that 2.5% becomes, especially when compounded over the years. In other words, costs kill when your portfolio keeps doubling every six months, but when it's doubling every 10 years or so -- costs kill you dead!

What you can do about itFrankly, I don't share Bogle's outlook for stocks. I think we'll do better from here, especially given the severity of the recent pullback. But even if we make three times as much as Bogle expects, we'll fork over well more than $100,000 in intermediation costs every 20 years.

If you resent that, here's a solution a lot of folks are considering: Start managing your own investments. Of course, you don't have to jump in all at once, and you don't have to dump all your funds right away. But you can see how important it is that you give it some thought -- and soon. All you need is a few great stocks.

For that, give Motley Fool Stock Advisor a look. You get two top recommendations each month straight from Motley Fool co-founders David and Tom Gardner, and it's free for 30 days. There's no pressure to join -- and if you do decide to join after your trial, it sure as heck won't cost you $100,000. To learn more about this special free trial, click here.

This article was originally published Sept. 29, 2006. It has been updated.

Paul Elliottowns shares of Johnson & Johnson, a Motley Fool Income Investor recommendation. You can see all of David and Tom's recommendations instantly with yourfree trial. The Fool has adisclosure policy.